Mergers & Acquisitions

Mergers and acquisitions (M&A) is a general term used to describe the consolidation of
companies or assets through various types of financial transactions, including mergers,
acquisitions, consolidations, tender offers, purchase of assets and management acquisitions. The
term M&A also refers to the desks at financial institutions that deal in such activity.

Difference between Merger and Acquisition

The terms "mergers" and "acquisitions" are often used interchangeably, although in actuality, they
hold slightly different meanings. When one company takes over another entity, and establishes
itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target
company ceases to exist, the buyer absorbs the business, and the buyer's stock continues to be
traded, while the target company’s stock ceases to trade.

On the other hand, a merger describes two firms of approximately the same size, who join forces
to move forward as a single new entity, rather than remain separately owned and operated. This
action is known as a "merger of equals." Both companies' stocks are surrendered and new
company stock is issued in its place.

Types of Mergers & Acquisitions

I. Merger

In a merger, the boards of directors for two companies approve the combination and seek
shareholders' approval. Post-merger, the acquired company ceases to exist and becomes
part of the acquiring company. For example, in 2007 a merger deal occurred between
Digital Computers and Compaq, whereby Compaq absorbed Digital Computers.

II. Acquisition

In a simple acquisition, the acquiring company obtains the majority stake in the acquired
firm, which does not change its name or alter its legal structure. An example of this
transaction is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial
Services, where both companies preserved their names and organizational structures.

III. Consolidation

Consolidation creates a new company. Stockholders of both companies must approve the
consolidation. Subsequent to the approval, they receive common equity shares in the new
firm. For example, in 1998, Citicorp and Traveler's Insurance Group announced a
consolidation, which resulted in Citigroup.

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IV. Tender Offer

In a tender offer, one company offers to purchase the outstanding stock of the other firm,
at a specific price. The acquiring company communicates the offer directly to the other
company's shareholders, bypassing the management and board of directors. For
example, in 2008, Johnson & Johnson made a tender offer to acquire Omrix
Biopharmaceuticals for $438 million. While the acquiring company may continue to exist
— especially if there are certain dissenting shareholders — most tender offers result in
mergers.

V. Acquisition of Assets

In an acquisition of assets, one company acquires the assets of another company. The
company whose assets are being acquired must obtain approval from its shareholders.
The purchase of assets is typical during bankruptcy proceedings, where other companies
bid for various assets of the bankrupt company, which is liquidated upon the final transfer
of assets to the acquiring firms.

VI. Management Acquisition

In a management acquisition, also known as a management-led buyout (MBO), a

company's executives purchase a controlling stake in another company, making it private.
These former executives often partner with a financier or former corporate officers, in an
effort to help fund a transaction. Such M&A transactions are typically financed
disproportionately with debt, and the majority of shareholders must approve it. For
example, in 2013, Dell Corporation announced that it was acquired by its chief executive
manager, Michael Dell.

The Structure of Mergers

Mergers may be structured in multiple different ways, based on the relationship between the two
companies involved in the deal.

I. Horizontal merger:
Two companies that are in direct competition and share the same product lines and
markets.

II. Vertical merger:

A customer and company or a supplier and company. Think of a cone supplier merging
with an ice cream maker.

III. Congeneric mergers:

Two businesses that serve the same consumer base in different ways, such as a TV
manufacturer and a cable company.

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IV. Market-extension merger:
Two companies that sell the same products in different markets.

V. Product-extension merger:
Two companies selling different but related products in the same market.

VI. Conglomeration:
Two companies that have no common business areas.

Valuation Methods
Both companies involved on either side of an M&A deal will value the target company differently.
The seller will obviously value the company at the highest price as possible, while the buyer will
attempt to buy it for the lowest possible price. Fortunately, a company can be objectively valued
by studying comparable companies in an industry, and by relying on the following metrics:

I. Comparative Ratios:

The following are two examples of the many comparative metrics on which acquiring
companies may base their offers:

a) Price-Earnings Ratio (P/E Ratio):

With the use of this ratio, an acquiring company makes an offer that is a multiple of the
earnings of the target company. Examining the P/E for all the stocks within the same
industry group will give the acquiring company good guidance for what the target's P/E
multiple should be.

b) Enterprise-Value-to-Sales Ratio (EV/Sales):

With this ratio, the acquiring company makes an offer as a multiple of the revenues, again,
while being aware of the price-to-sales ratio of other companies in the industry.

II. Replacement Cost:

In a few cases, acquisitions are based on the cost of replacing the target company. For
simplicity's sake, suppose the value of a company is simply the sum of all its equipment
and staffing costs. The acquiring company can literally order the target to sell at that price,
or it will create a competitor for the same cost. Naturally, it takes a long time to assemble
good management, acquire property and purchase the right equipment. This method of
establishing a price certainly wouldn't make much sense in a service industry where the
key assets – people and ideas – are hard to value and develop.

III. Discounted Cash Flow (DCF):

A key valuation tool in M&A, discounted cash flow analysis determines a company's
current value, according to its estimated future cash flows. Forecasted free cash flows (net

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 income + depreciation/amortization - capital expenditures - change in working capital) are
discounted to a present value using the company's weighted average costs of capital
(WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation
method.

Advantages of Mergers and Acquisitions

I. Synergy

The synergy created by the merger of two companies is powerful enough to enhance
business performance, financial gains, and overall shareholders value in long-term.

II. Cost Efficiency

The merger results in improving the purchasing power of the company which helps in
negotiating the bulk orders and leads to cost efficiency. The reduction in staff reduces the
salary costs and increases the margins of the company. The increase in production
volume causes the per unit production cost resulting in benefits from economies of scale.

III. Competitive Edge

The combined talent and resources of the new company help it gain and maintain a
competitive edge.

IV. New Markets

The market reach is improved by the merger due to the diversification or the combination
of two businesses. This results in better sales opportunities.

Disadvantages of Mergers and Acquisitions

I. Bad for Consumers

With the merger, competition can reduce the industry and the new company may have
higher pricing power.

II. Decrease in Jobs

A merger can result in job losses. An acquiring company may shutdown the under-
performing segments of the company.

III. Sometimes Dis-economies of Scale

The increased size may lead to dis-economies of scale for the new company. It may not
have the control required for running a bigger company.

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